The Federal Reserve Bank of the United States is the Central Bank of the United States. Virtually all countries have a Central Bank. The main exception to this is the European Union, which created a common currency, the Euro, in 1999. The EU has 27 members and 23 of them currently use the Euro as their official currency. As a result, the EU created the European Central Bank, which functions as the Central Bank for countries using the Euro. The key function of these Central Banks is threefold:
- It monitors the banks and other financial institutions in the country to make sure they are following its rules and are acting in a financially responsible manner. The Central Bank has great power in this area and can shut down banks, either on its own or (in the United States) through the Federal Deposit Insurance Corporation, which guarantees all the deposits at U.S. banks.
- It controls key interest rates, such as rates for bank borrowings and, indirectly through the prime rate, commercial lines of credit for companies. It also indirectly influences longer-term rates such as car loans and mortgages.
- It also controls the money supply.
These activities all together are called monetary policy. The Federal Reserve Bank (or “the Fed”) is made up of three key entities:
- The Federal Reserve Board of Governors. The seven governors are appointed by the President of the United States and serve for fourteen years each. Their terms are staggered so that one governor’s term expires every two years. This arrangement prevents one President from controlling the Fed through their appointments. The Chair of the Federal Reserve Board of Governors is also appointed every four years by the President.
- The Federal Reserve Banks. There are twelve Federal Reserve Banks in the United States and these are effectively local offices of the Fed. The United States is divided into twelve Federal Reserve Districts, with a Federal Reserve Bank monitoring the commercial banks in each district and each Federal Reserve Bank is headed by a President.
Figure 4.2. Federal Reserve Districts Map – Banks & Branches by ChrisnHouston is used under a CC BY-SA 3.0 License. - The Open Market Committee. The Open Market Committee dictates monetary policy. It has twelve members and is composed of the seven members of the Board of Governors, the President of the New York District Federal Reserve Bank , and four additional Presidents of the District Federal Reserve Banks, each of whom serves on a rotating basis for one year. The Open Market Committee meets every six weeks to decide on monetary policy. In addition to the function and structure of the Fed, we also need to understand the mandate of the Fed. According to the various laws creating and underpinning the Federal Reserve Bank, it has a dual mandate:
- To maintain low and predictable rates of inflation
- To maintain maximum levels of employment that are sustainable.
The Fed meets these mandates by controlling the amount of money in the economy. This indirectly influences the amount of goods and services bought in the economy.
The total amount of goods and services made and purchased in any economy in a specific time period (usually a year) is called the Gross Domestic Product (GDP) of an economy. If we look back over the last forty years of the U.S. economy, the empirical evidence tells us that the ratio of the GDP purchased each year to the M2 is pretty constant. Specifically, it is a ratio of approximately 2 to 1.
The technical term for this ratio is the Velocity of Circulation. The relatively constant Velocity of Circulation has three important implications for Monetary Policy. First, this constant 2 to 1 ratio means that every dollar of money in the economy buys two dollars of GDP over the course of a year. Second, it also means that if the Fed wants to influence the growth of GDP, it needs to create $1 of Money for every $2 of GDP it wants to stimulate. Third, the growth rate of M2 needs to be equal to the growth rate of GDP or the lack of money will slow down the growth of GDP. The relatively constant ratio of GDP to M2 is an important assumption of the Quantity Theory of Money, as espoused by the Monetarist economists. Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods (Wikipedia).
The standard bearer of Monetarism was Nobel Laureate Milton Friedman of the University of Chicago. Unfortunately, although the ratio of GDP to M2 was fairly constant in the 1960s and 1970s when Friedman was doing his Nobel Prize-winning research, it is no longer true (see graph below). This discrepancy now calls into question the validity of Monetarism.
Figure 4.3. Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis; September 30, 2021.
Firms need employees to make things and provide services, and we can get pretty specific about how many people will be employed based on additional GDP purchases. In 2018, if we take the total GDP and divide it by the number of employed people, we get this result:
Thus we see that for every $131,600 in GDP purchased throughout the course of the year, the economy needs to hire on average one additional worker. This is how the Federal Reserve Bank influences employment.
As for inflation, the Fed influences this by maintaining the growth of M2. Simply put, inflation is caused by too much money trying to buy fewer goods and services, thus raising prices. This can be expressed in the Inflation Equation from the economic Quantity Theory of Money:
Although this does not hold exactly for every year, it is true over the long run (ten years or more), and we see that the actual data support this relationship. An important way to interpret this equation (for our purposes) is that if the money supply is growing more quickly than the supply of goods and services available to purchase, then prices will rise. As we said, this general rise in the prices in an economy is called inflation. Therefore, we see that the Fed can influence employment by increasing the money supply or reduce the rate of inflation by decreasing the money supply. Unfortunately, these dual mandates are sometimes in conflict, and when they are, the Fed will always choose controlling inflation over achieving maximum employment. In the past, the Fed has sometimes put the economy into a recession in order to control inflation.
The Fed is very interested in controlling expectations in the marketplace, and it has been very clear about its targets for maximum employment and low and stable prices. The Fed is trying to achieve the natural rate of unemployment. The determination of this rate is an empirical question, not a theoretical one. The natural rate of unemployment is the rate which if we go below it wages generally rise (wage inflation), and this then causes general inflation in the economy. The Fed used to think the natural rate of inflation was 4.5%, but at the end of 2019, the unemployment rate is 3.7% without seeing any significant inflation in the economy.
As to the ideal inflation rate, the Fed set a target of a 2% general rise in prices over the course of a year. We might call this target Goldilocks inflation, as the Fed does not want the rate of inflation to be much higher or much lower than this. Higher inflation can feed on itself (through inflation expectations), while lower inflation can cause consumers to hold off their spending. I should note that the Fed targets core inflation, which is the rise in GDP prices, and it eliminates food and energy prices from the calculation, as they are too volatile.
In order to control the money supply and therefore short-term interest rates, the Fed conducts Open Market Operations. If unemployment is too high, the Fed buys Treasury Bonds from the banks, thereby increasing their Reserves (the banks’ money that has not yet been lent out). This increases the money supply and lowers interest rates, stimulating the economy through the availability of cheaper borrowing rates for all loans. If inflation is too high the Fed sells Treasury Bonds to the banks, thereby decreasing their Reserves. This decreases the money supply and increases interest rates and slows down the economy due to more expensive borrowing rates.